Lenders and investors closely scrutinize contract terms to assess the bankability of a project, as the allocation of risk between owner and contractor can significantly affect the likelihood of successful completion and the repayment of the substantial capital investments required to realize large projects.
Two common contract types, and the topic of this article, are cost reimbursable and lump sum turnkey (LSTK) contracts, both of which seek a single contractor to deliver the works, but which differ materially with respect to the balance of risk between the parties.
A cost reimbursable contract is an agreement where the contractor is paid for all legitimate project costs incurred, plus an additional fee that reflects the contractor’s profit. In contrast, an LSTK contract is a fixed-price agreement where the contractor delivers the complete project for a set price, assuming most of the risk for cost overruns.
Each approach allocates risk and responsibility differently between the project owner and the contractor, and recent market trends are influencing which model is preferred (or available) for certain types of large-scale projects.
Historically, LSTK contracts have been favored for their perceived bankability and ability to, at least in principle, provide greater delivery certainty and cap cost risk for owners and lenders
However, the global construction market is experiencing significant changes. Factors such as inflation, commodity price volatility, supply chain disruptions, increased demand, and geopolitical instability have exposed the limitations of the LSTK model. Contractors are increasingly reluctant to take on substantial design, technology, and market risks, especially for large or complex projects and particularly in the energy sector. This has led to a growing prevalence of cost-reimbursable contracts for projects involving new technologies or significant uncertainties. Nevertheless, LSTK contracts may still be preferable for well-defined, low-risk projects where scope and owner requirements are clear from the outset.
Key differences between cost reimbursable and LSTK contracts
Risk allocation
- LSTK contracts: The contractor assumes most of the cost and performance risk, delivering the project for a fixed price. Any cost overruns are generally the contractor’s responsibility, although in practice, owners may still face additional costs through change orders and significant disputes can arise as to the impact of owner-related risks. In truth, there is no such thing as an absolute fixed price contract.
- Cost reimbursable contracts: The owner pays the contractor for actual costs incurred, albeit subject to certain processes and limitations to ensure only properly incurred costs are recoverable, plus an agreed fee or markup. The owner bears the risk of cost overruns but gains greater control and transparency over project execution. Incentive mechanisms can be used to align the interests of the parties.
Cost certainty:
- LSTK contracts: Offer a high degree of cost certainty for owners, as the price is fixed at the outset. Contractors often include significant contingencies in their pricing to cover potential risks, which can lead to higher initial costs. Adjustments, which can be significant, may still occur for owner-driven changes or unforeseen circumstances.
- Cost reimbursable contracts: Costs are not capped, so the final project price will vary. This model requires robust cost management and oversight by the owner to mitigate the risk of cost escalation.
Project control and flexibility:
- LSTK contracts: Owners have limited control over how the contractor achieves the project outcome, focusing mainly on the result, with limited focus on “how” that result is achieved. This lack of control also means a lack of ability to mitigate those cost and delay risks which are retained by the owner.
- Cost reimbursable contracts: Owners can exercise significant oversight and influence over project execution in real time, including scope changes, design decisions, and cost management. There is a greater focus on “how” a result is achieved, not just whether it is achieved.
Incentivization:
- LSTK contracts: There are limited incentives for cost savings as the contractor’s focus is on delivering within the fixed price. If any savings arise, they are for account of the contractor. Contractors will naturally be incentivized to seek opportunities to reopen the fixed price, particularly where the contractor’s cost contingencies prove to be insufficient.
- Cost reimbursable contracts: Appropriate incentive mechanisms can be built into a well-structured cost reimbursable contract, such as sharing cost savings below a target cost or sharing overruns by reducing profit or overhead above a target cost or with the introduction of a guaranteed maximum price, to align contractor and owner interests. However, such structures do have practical limits in terms of the lack of overall jeopardy to which the contractor is exposed.
Key protections in cost reimbursable contracts
The shift toward cost reimbursable contracts does not necessarily make projects less financeable, although they will likely affect the terms upon which financing is available. With proper structuring, clear contract terms, and strong project management capabilities, owners can successfully manage the risks associated with this model. Owners must, however, be prepared to take a more active role in project oversight, including detailed scope management, cost audits, and claims review.
To manage the increased risk exposure in cost reimbursable contracts, owners should focus on several critical protections:
- Clarity of scope and execution plan: Clearly define the work scope and execution plan to limit the contractor’s entitlement to reimbursement. Vague descriptions allow inefficiency and can lead to broad claims for additional costs.
- Detailed definition of reimbursable and excluded costs: Specify which costs are reimbursable and which are excluded (such as costs due to contractor negligence, or defect correction, noting that all of these aspects are negotiable) through a thorough and detailed cost schedule. Additionally, and to the extent possible, eliminating hidden costs embedded within hourly rates so as to ensure transparency, commercially focusing the contractor on achieving the owner’s objectives and maintaining a truly “open book” contract should drive “best for project” contractor behavior.
- Profit and overhead structure: Clearly distinguish between profit and corporate overhead. Profit should ideally be fixed as a specified sum rather than a percentage of costs to avoid incentives for cost escalation. Corporate overhead should for the same reasons also be clearly defined and, where possible, fixed or capped.
- Subcontracting controls: Implement robust controls over subcontracting, especially for subcontracts with affiliates or those above a specified threshold of value or core importance. This helps prevent excessive profit-taking by the contractor using subcontractors to siphon out profit without the incentives and controls that exist in the prime contract.
- Cost control incentives: Establish a target cost and an incentive regime to encourage cost savings. Savings below the target cost can be shared between the owner and contractor, while overruns can be shared or ideally capped through a guaranteed maximum price structure (noting that this may not be available in the market on complex projects). Invoicing procedures must be robust, with clear requirements for supporting documentation. Consider the inclusion of a maximum payment schedule to manage cash flow. Reduce the circumstances permitting the contractor to adjust the target cost, for example, by implementing strict change order procedures.
- Robust administrative controls: Ensure strong cost auditing rights, effective claims management, and regular reporting to maintain transparency and control over project expenditures.
While cost reimbursable contracts offer flexibility and transparency, they also expose owners to the risk of cost escalation and require significant owner-side project management resources. Owners must be prepared to actively monitor costs, manage scope, and enforce contract terms to avoid budget overruns.
Conclusion
The construction industry is evolving, and for larger, complex or new technology projects there is a noticeable trend away from LSTK contracts toward cost reimbursable structures. While this shift places more responsibility on owners, it also offers greater flexibility, transparency, and potential for commercial alignment. The optimal contract structure depends on project specifics, market conditions, and the risk appetite of the parties involved.
Success under a cost reimbursable model depends on careful contract drafting, diligent project management, and the implementation of key protections to balance risk and incentivize performance. By understanding the fundamental differences between these contract types and adapting to current market realities, project stakeholders can better navigate the challenges and opportunities of today’s construction landscape.
